Understanding the differences between an initial margin and a maintenance margin is a key concept for anyone who decides to trade on margin. Trading on margin is not commonly done in stock trading except by professional investors and institutional traders. However, trading on margin is standard practice in the futures markets and forex (FX) trading. The ability to trade on a relatively low margin, with high leverage, is part of what attracts many speculators to futures and forex trading.
- Trading on margin is common for futures and forex traders and refers to the practice of paying only a portion of an investment's price, which is called the margin.
- In futures trading, the margin requirements can be as low as 3% to 12% of the traded contract value.
- The initial margin is the amount a trader must deposit with their broker to initiate a trading position.
- The maintenance margin is the amount of money a trader must have on deposit in their account to continue holding their position, which is typically 50% to 75% of the initial margin.
- In futures trading, if the funds in the margin account drop below the maintenance margin level, the trader will receive a margin call requiring the immediate addition of more funds to increase the account back to the initial margin level.
Trading on Margin
When security traders buy on margin, they pay only a portion of the stock price, which is called the margin. They borrow the balance of the stock price from a stockbroker. The stocks the trader has purchased then serve as collateral for the loan. An investor who buys stocks on margin must establish a margin account with their broker, which allows them to borrow funds from their broker without paying the full value for each trade.
Trading stocks on margin is most common in short selling. According to Regulation T of the Federal Reserve Board, the initial margin requirement allows traders to borrow up to 50% of the purchase price of equity securities purchased on margin. The actual amount will depend upon the broker's requirements and some brokers may require the trader to have more than 50% on deposit.
In futures and forex trading, the margin requirements are much lower—as low as 1% to 5% of the traded contract value. Margins on futures contracts are typically 3% to 12% per contract. The margin posted by a trader represents a good faith deposit that the trader must keep on hand with the broker. This affords the trader a high level of leverage to greatly amplify the effect of price changes in terms of the dollar amount of gain or loss in the trader's account.
If the market moves in the trader's favor, this leverage enables the trader to realize significant profits on even small price changes. However, if the market moves against the trader's position, a moderate price shift amplified by the leverage used can lead to losses greater than the trader's margin deposit.
When trading on margin, an investor should also consider the interest or other fees charged by their broker in order to calculate the true cost of the trade and the profit or loss potential.
Initial Margin Requirements
The initial margin requirement is the amount a trader must deposit to initiate a trading position. For futures contracts, the clearinghouse sets the initial margin amount. Brokers, however, may require traders to deposit additional funds beyond the initial margin requirement in order to establish and maintain the account.
Once a futures trading position is established, a trader must maintain a certain balance established by the broker—typically 50% to 75% of the initial margin—to continue holding the position.
In futures trading, if the account falls below the specified maintenance margin level, then the broker sends the trader a margin call. This informs the trader that they must immediately deposit sufficient funds to bring the account back up to the initial margin level. If the trader fails to do so promptly, the broker will close out the trader's market position.
Example of Initial Margin and Maintenance Margin
If the initial margin requirement for trading one gold futures contract is $1,000 and the maintenance margin requirement is $750, then if the balance in the trader's account drops to $725, the trader must deposit an additional $275 to bring the account back to the initial margin level.
Another alternative is for the trader to sell other investments in the portfolio to raise the funds needed to bring the account back to the initial margin level. If the trader fails to respond to the margin call in a timely fashion or does not have the money to bring the account back up to the initial margin, the broker can then liquidate the position. Some brokers may automatically liquidate a position once it drops below the maintenance margin level.